Between a Netflix show about a ghost ship that is oddly fixed in position and a WSJ article about a bounty of Yeti coolers washing up on beaches, an ocean motif is saturating our weekend.
Apparently, the study of objects moving on ocean currents is known as flotsametrics and a person engaged in such an occupation is a flotsamologist. As we think about recent action in the markets, it strikes us that flotsamology may have the edge vs. equity analysis in predicting where goods are headed. Of course, the trick is still to filter the treasures from the trash.
U.S. Consumer to Fed: We Haven’t Blinked
A year ago, we wrote and thought that employment and wages were a more important investment consideration than inflation. Consumer spending is 2/3 of the U.S. economy. The single most relevant factor in consumer spending is jobs. When U.S. consumers have incomes, they spend. Saving is what happens for Americans when the spending is done, not the other way around. More than 20 years of experience following the consumer sector has taught us not to bet against the U.S. consumer’s propensity to spend. This mental model partially explains why we underestimated the importance of rising interest rates at the start of 2022 and failed to anticipate the impact on stock prices and valuations. However, as 2022 draws to a close, industry data and our conversations with U.S. consumer companies indicate that spending remains very robust despite the headwinds.
Check out the chart below of monthly retail sales (consumer spending) from 2005 to present. A couple of observations about this chart. First, note the dip in the wake of the Great Financial Crisis (2008-2009) and subsequent recovery. During the crisis, many consumer stocks were priced as if the consumer was never coming back, but in retrospect the drop was only an interruption, not the end. Secondly, the most recent data points (right part of the chart and circled in red) show that little impact from the Fed’s higher 2022 interest rate hikes. Kinda like a big middle finger held up to Jerome Powell.
Meanwhile, the signal that interest rate increases will slow has spurred a rebound in equities, especially those in the consumer sector. There has been a very slight reduction in some inflationary data (emphasis on slight) and the Fed has indicated that will reduce the size of upcoming rate increases while observing and measuring their impact (which occurs with an unknown time lag). This subtle shift, together with still-strong consumer activity, has reversed some of the negativity in equities. An index of discretionary consumer stocks that we follow is up more than 20% over the past two months.
When we think about overall equity prices (the stock market) we believe the most important factors are expected future corporate earnings, the direction of revisions to estimates for earnings, and investor sentiment. Our view is that the value of a company is determined by its future earnings and cash flow, discounted for the time it will take for these earnings and cash flow to be produced, and adjusted for each business’ special assets (such as patents or brands) and risk profile including its balance sheet (debt levels). The market price of a stock on any given day is only loosely tethered to this underlying fundamental value. Investors are influenced, among other factors, by near-term changes in earnings estimates and by longer-term sentiment about where things are going. During 2022, overall earnings expectations for the S&P500 have been revised lower, which has hurt stocks. Negative sentiment about the future has been an even larger factor driving stock prices down. In this context, only a small improvement in fundamentals or the outlook was needed to generate a ray of hope and bounce prices.
Wall Street Complicity in the Bitcoin Crypto Wipe Out Contains a Message Worth Noting and Repeating
Was anyone really surprised that a 30-year crypto billionaire promising to give away all his (misappropriated) money was a fraud? Everyone who works in finance should know that there is no financial method to ascribe any value to a bitcoin. Yet, despite this fact, the financial media, investment banks, and fund management companies jumped to participate in the crypto-bonanza.
It’s possible that the circus of enablers around Sam Bankman-Fried (SBF) led him to believe his own snake oil pitch. However, what about those who should have known better? We’re thinking of one of the largest mutual fund companies that we won’t name because they have an army of lawyers and we don’t. You can find out which one by reading this article about their offer to have you put crypto-nonsense tokens into your 401k. Let’s imagine a conversation between a sales rep from this company and a potential client:
Sales rep from unnamed large mutual fund company: “Hello Mr. & Mrs. Smith. I have great news! You can now put crypto into your 401K including bitcoin, solana, and polkadot!”
Mr. & Mrs. Smith: “Polkadot, like on a necktie and such?”
Sales rep from unnamed large mutual fund company (has never worn a necktie): “Polkadot is a number constrained free-coin digital token!”
Mr. & Mrs. Smith: “Isn’t it risky to put our retirement in crypto? How do you know what it’s worth?”
Sales rep from unnamed large mutual fund company: (consulting sales literature) “Polkadot’s value is fixed via a network of verification nodes on the blockchain, mined by self-learning algorithm. Only a six delta event riding a black swan could unfold the wallet!”
Mr. & Mrs. Smith: “How much of our retirement assets should we allocate to this?”
Sales rep from unnamed large mutual fund company: (considering commission incentives) “You’re currently at zero percent crypto and completely undiversified. I recommend 100% of future contributions until your 401K is properly balanced!”
Mr. & Mrs. Smith: “Does it pay a dividend?”
Sales rep from unnamed large mutual fund company: (sensing the close) “Yes! Polkadot pays quarterly Robux you can use to buy real estate in the metaverse or to upgrade your avatar!”
End of conversation.
Why would an allegedly responsible fund management business want to funnel customer funds into something that cannot be valued by any known financial method? Simple. There’s money to be made and they want their piece of the action. You don’t need a flotsomologist to understand that clients are getting the whorl.
A Difficult Year to Manage Investments*
We’ve avoided and continue to avoid the crypto-arnaques but won’t pretend that this has been a great year for us. It has not. Our approach is to stay invested, not try to “time” or call the market, and to own very high-quality companies that can grow. From a sector perspective, we are biased to invest in the consumer names we know and we also like understandable technology companies with high margins and defensible models. We have generally attempted to initiate positions opportunistically on market sell-offs (when available) and normally we won’t sell when prices rise, instead focusing on limiting taxable gains with a look towards the long-term (multi-year) potential for compounding.
This strategy worked very well for us for the three years leading up to 2022, with our best performance occurring during 2020 when the market panicked around Covid. In 2021 the market gained 29% and it was difficult not to make money owning stocks. However, these gains left our book valuation exposed as we entered 2022. We have stuck with our strategy and as prices have fallen this year we’ve added to our technology sector holdings (in profitable, growing companies). The sector remains out of favor as 2022 concludes and an uncertain environment with still-rising interest rates is likely next year.
Nevertheless, the attractive qualities of the businesses we own have not changed. When we review the expected growth in earnings and cash flows and assume a return to historical valuations (not to 2021 levels) we believe these investments have the potential to generate very attractive gains. However, we don’t know what will happen or when this could occur. Regarding 2023, our company contacts are telling us that inflation is going to remain at least in the mid-single-digit percentage rates which suggests interest rates will keep marching higher and implying ongoing risk to both the economy and the markets.
*Talk to your financial advisor about what is appropriate for your investment and risk profile.
John Zolidis
President & Founder
Quo Vadis Capital, Inc.
John.zolidis@quovadiscapital.com
Mr. Zolidis founded Quo Vadis Capital, Inc., a Registered Investment Advisor (RIA) and research consultancy, in 2017. He started his career in finance in 1996 following degree studies in Philosophy at Kenyon College and the University of Oxford. He has followed U.S. consumer companies as a senior analyst since 1999, mostly on the sell-side, writing research for institutional investor clients. He also managed money in a buy-side role at a long-short equity fund over 2013-2014. He was named in the Wall Street Journal’s Best on the Street list in 2005. Mr. Zolidis and works from New York, NY and Paris, France or wherever he has his laptop.
Travel update: Two December trips: First, New Orleans, Chicago, New York and second, a family voyage to Florence to Rome. This week I am kicking off a mini-tour of the U.S. with a trip to New Orleans to visit my daughter Ophélie, who is a sophomore at Tulane University. I will also spend a day visiting retail and have my eye on some very exciting discount stores, big box retailers and sporting goods stores. Next up will be Chicago where I am attending a birthday party for a friend I’ve known since middle school. He’s not an “old friend” but un ami de longue date, as they say in French. I’ll also been hitting more stores and have set up several meetings. Lastly, I will swing by my place in Long Island to make sure no racoons have installed themselves in my chimney since the last time I was there. I may even deign to set foot in NYC on my way out.
Last month, I traveled to Dubai and gave two presentations at a value investing conference, Valuex Middle East. Thank you to my friend Guy Spier for encouraging me to set up a youtube channel for Quo Vadis Capital where I uploaded a video of one of my talks from Dubai. The topic is a bit technical, it’s about short selling, but if you’d like to check it out, please follow this link.
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